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How many attractive stock ideas does Naomi, an institutional active equity fund manager, have at any one time?
“Oh, I think between 10 and 20,” she told me.
So, why did her fund hold so many more times that number of stocks?
“To round out the portfolio,” she said.
I have asked these same questions of many active equity managers and received similar responses each time. The implication, of course, is that these managers are drowning the superior performance potential of their best ideas in a sea of bad ones.
Why would they hobble their returns in this way? After all, no expert chef would serve up their signature dish with generic supermarket bread. Why do skilled stock pickers make such errors when constructing portfolios, and what can we do about it?
Are professional managers skilled stock pickers?
The consensus is “no,” they are not. On average, active equity funds fail to meet their benchmarks, which suggests that investors should avoid them in favor of low-cost index funds.
But what if managers like Naomi stuck to their 10 to 20 preferred stocks? Would their portfolios do better? Studies confirm that they would. In the most compelling of these, “Best Ideas,” Miguel Anton, Randolph B. Cohen, and Christopher Polk find that the performance of the top 10 stocks held by active equity mutual funds, as measured by portfolio weights relative to index weights, significantly exceeded their benchmarks. As the relative weights decline, however, performance faded and at some point, probably around the 20th stock, fell below the benchmark.
Professional managers are superior stock pickers – if they stick with their 10 to 20 best ideas. But most mutual fund portfolios hold many more bad ideas than best-idea stocks.
Collective stock-picking skill
Applying a variation of the “best ideas” relative-weight methodology, my firm, AthenaInvest, rates stocks by the fraction held by the best active equity funds. We define the best funds as those that pursue a narrowly defined strategy and take high-conviction positions; we update our objective fund and stock ratings based on monthly data. The best and worst idea stocks are, respectively, those most and least held by the best U.S. active equity funds. We derive each stock’s rating from the collective stock-picking skill of active equity funds with distinct strategies.
The following chart presents the annual net returns of best and bad idea stocks from 2013 to 2022 as distilled from more than 400,000 stock-month observations. The two best ideas category stocks eclipsed their benchmarks by 200 and 59 basis points (bps), respectively, as measured by the average stock return net of the equally weighted S&P 500. The bad idea stocks, by contrast, underperformed. (These results would have been even more dramatic had we excluded large-cap stocks, since stock-picking skill decreases as market cap increases (the smallest market-cap quintile best idea returns far outpaced those of the large-cap top quintile best ideas).
Performance declined as the best funds held less and less of a stock. Those held by fewer than five best idea funds – the rightmost category – returned -646 bps.
The designations reflect AthenaInvest’s roughly normal distribution rating system. The two best idea categories comprise 24% of the market value held by funds, while the bad ideas account for 76% and so outnumber good ones by more than 3 to 1.
The market value-weighted average annual return of all stocks held by funds was -53 bps before fees. Yet had the funds invested only in best ideas, they would have exceeded their benchmark. By diversifying beyond their best ideas, stock pickers sacrificed performance to build bad-idea funds and became, in effect, closet indexers.
Investing in bad ideas
Again, why would they do this? Reducing portfolio volatility could be one motivation. But that only goes so far. On average, a 10-stock portfolio has a 20% standard deviation, less than half a one-stock portfolio’s 45% volatility. Adding stocks within this range makes sense. But beyond it, not so much: a 20-stock portfolio yields only an 18% standard deviation and so on. After a certain point, adding bad ideas only drags down returns without contributing much diversification.
But if diversification cannot explain investing in bad ideas, what can? Emotional triggers are a key driver. Despite the evidence, many see holding a 10-to-20-stock portfolio as “risky.” But if stocks sit in a portfolio’s long-term growth bucket, then short-term volatility is not a true risk. In fact, holding only one’s best ideas may be less risky since they should lead to greater long-horizon wealth. Small portfolio skittishness is therefore an emotional reaction motivated by a desire to reduce risk rather than create wealth.
Tracking error is another emotional trigger. With its small, unique set of stocks, a best-idea portfolio will have periods of both under- and out-performance. Since investors often suffer from myopic loss aversion, they are prone to overreacting to short-term losses. To alleviate their sense of disappointment, they may sell low and buy high, trading an underperforming fund for an outperforming one. To minimize this business risk, funds may overdiversify to ensure their performance tracks their benchmark even at the expense of long-term returns.
Since funds charge fees based on their assets under management (AUM) rather than performance, they are incentivized to grow ever larger and become closet indexers. In “Mutual Fund Flows and Performance in Rational Markets,” Jonathan B. Berk and Richard C. Green described the economic rationale for such return-sabotaging behavior.
Investment consultants and platform gatekeepers further reinforce these trends. They both apply standard deviation, tracking error, and the Sharpe ratio, among other tools of modern portfolio theory (MPT), to determine whether to include certain funds in a portfolio. Based on short-term volatility, each of these measures may encourage myopic loss aversion in investors. Instead of mitigating such performance-destroying behavior, they exacerbate it.
This is especially true for the Sharpe ratio, which double discounts for short-term volatility. It reduces the compound return in the numerator while dividing by the standard deviation in the denominator. The clear signal is that when it comes to active equity mutual funds, no good idea funds need apply.
Avoiding bad ideas
The solution ought to be simple: Invest in active equity funds that confine their holdings to only the best ideas. But for the reasons I outlined, doing so isn’t easy.
Those who are unwilling or unable to invest in best-idea funds should opt for low-cost index funds. Those who are interested in high-performing, active equity funds and are not deterred by higher short-term volatility and tracking error should look for the following:
- Narrow-strategy funds
Invest in specialist not generalist funds. They’ll be doing something different and have expertise in their field.
- Narrow-strategy funds with long track records
To be sure, this does not imply that returns will be consistent, only that the strategy will be.
- Best-idea funds with different strategies
Since performance ebbs and flows, investing in four or five best idea funds with distinct strategies can smooth out the ride.
- High-conviction funds with fewer stocks and lower AUM
Think funds with fewer than 30 stocks and less than $1 billion in AUM. According to my firm’s active equity fund analysis, fewer than 15% of high consistency, high conviction funds exceed this AUM threshold.
- Funds with an R-squared of 0.60 to 0.80 relative to their benchmark
As an alternative, measure fund conviction by comparing each fund’s R-squared to its benchmark. Lean toward those with scores that fall in this range.
Turning the tide on closet indexing
Most active equity funds do not underperform for lack of stock-picking skill. Rather, the investment industry incentivizes them to indulge their clients’ most unproductive emotional triggers and manage business risk at the expense of long-term portfolio performance.
We all need to do our part to change this dynamic and reverse the trend toward closet indexing. Whatever you do, don’t invest in bad-idea funds.
C. Thomas Howard is the co-founder, chief investment officer, and director of research at AthenaInvest. Building upon the Nobel Prize-winning research of Daniel Kahneman, Howard is a pioneer in the application of behavioral finance for investment management. He is a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where he taught courses and published articles in the areas of investment management and international finance. He is the author of Behavioral Portfolio Management. Howard holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
